NOW Inc: A GARP Investment Opportunity

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Oct 09, 2014
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Legendary Fidelity manager Peter Lynch popularized the "GARP" investment strategy (growth at a reasonable price). Today, I found a good GARP investment candidate. It is NOW Inc (DNOW, Financial).

DNOW trades at a reasonable price for a 16x P/E multiple of its expected $1.73 EPS in 2015. Most investors first reaction is why they would buy a reasonably priced stock. The answer is that DNOW has superior management team, great track record of mergers and acquisitions, strong balance sheet after recent spin-off from National Oilwell Varco, Inc. (NOV), low maintenance capital expenditures business model, and operating efficiency with the integration of the new ERP system. I will discuss all of those great characters of DNOW more in detail later in this article.

Company Overview

DNOW is one of the largest distributors of energy and industrial products to upstream, midstream, downstream, and industrial markets in the United States, Canada, and internationally. The Energy branches, which consist of 83% of total sales, provide products such as pipes, valves and valve automation, fittings, mill and industrial supplies, tools, safety products, and artificial lift systems. The Supply Chain division consists of 17% of total sales, and provides supply chain management, project management, and e-commerce solutions. DNOW has a vision to become the market leader in supply chain management through superior customer service by leveraging the strengths of employees, processes, suppliers and information. DNOW has about 330 locations in more than 20 countries, and more than 5,300 employees. DNOW has been in business for more than 150 years.

The presentation slide below provides more details for investors to see how powerful DNOW is:

(click to enlarge)03May20171348591493837339.png

Source: Company Presentation

After understanding the business of DNOW, let's focus on the great characteristics of DNOW below:

Experienced Management Team

(click to enlarge)03May20171348591493837339.png

Source: Company Presentation

One of the reasons I like DNOW is the experienced management team. For instance, Merrill Miller used to be the CEO and chairman of NOV, which has a $30 billion market cap. He chose to leave NOV and become the executive chairman of DNOW. This shows his confidence in the future of DNOW.

He also brought with him a highly experienced management team consisting of Robert R. Workman as the CEO of DNOW. Furthermore, the average tenures of all the management team members is about 20 years.

As a side note, Warren Buffet purchased NOV before the spin-off of DNOW. As we all know, if Warrent Buffet does not have confidence in a management team, he will not make an investment. That's a great testimony to the credibilities of DNOW's management team.

Please note that I provide cyberlink for both the CEO of DNOW and the chairman of DNOW for investors to further research the management background.

Great Track Record of Mergers and Acquisitions

(click to enlarge)03May20171348591493837339.png

Source: Company Presentation

DNOW's senior management team has vast experiences with M&A due to their time at National Oilwell Varco. As the targeted market of DNOW is highly fragmented, this creates even greater opportunity for DNOW to capture the growth opportunities and cost synergies.

Low maintenance capital expenditures business model

Since the run-rate maintenance capital expenditures are about $10-20 million per year, this enables DNOW to generate $235 million Free Cash Flow "FCF" in 2011, $264 million FCF in 2012, and $239 million FCF in 2013. As I listened to the latest conference call, I was impressed to hear that DNOW could generate the robust FCF in 2013 despite facing the headwinds of a down year in 2013 in the broad energy sector. Furthermore, management reiterated that their flexible cost structure and disciplined working capital management allowed them to generate good FCF through different cycles. Given the attractive business model with great visibility in strong FCF, I am delightful to have the opportunity to invest in DNOW at the current reasonable market valuation.

Operating efficiency with the new ERP system

For most system upgrades, there might be some hiccup. Frankly, this is what has just happened in DNOW. As a result, DNOW reported lower 2Q 2014 EPS of $0.25 compared to the street consensus of $0.30. However, the good news is that the ERP system implementation is almost done. Going forward, DNOW has a single integrated ERP system linking global branches, customers and suppliers. The benefits are increasing operational efficiency, quicker and more informed decision making, and lower total procurement costs for customers. That's why DNOW can project that its EBITDA will be benefited in the future and set the goal to be at least 8% EBITDA margins.

Outlook

(click to enlarge)03May20171348591493837339.png

Source: Company Presentation

From the above outlook provided by the management, I would like to stress two important points. First, the 8%+ EBITDA margin will greatly improve the profitability of DNOW, in addition to the future accretive mergers and acquistions. Second, the low maintenance capital expenditure helps to provide free cash flow for DNOW to do mergers and acquisitions without incurring much debt onto the balance sheet. Management has made their plan of disciplined capital allocation clear to investors. Together with their outstanding track record, I believe that DNOW will delivery an outperformance return for loyal shareholders.

Financial Strengths

Parent companies usually make spin-offs to raise funds and pay special dividends back to the parent. However, this is not the case with DNOW. DNOW was spun off debt free with $750 million undrawn revolver. DNOW also had approximately $200 million in cash on its balance sheet relative to its $3 billion market cap. This gave a lot of financial flexibility to pursue future mergers and acquisitions.

Valuation

DNOW's peer group, including Fastenal (FAST), WW Grainger (GWW), MSC Industrial (MSM), and WESCO International (WCC), has the EV/EBITDA ratio ranging between 10x and 12x. Because DNOW has low maintenance capital requirements and expected operational efficiency, it deserves to be traded close to 12x EV/EBITDA. As the EBITDA margins migrates towards to the management's target of 8% and above, this translates to my $40 target price for DNOW.

Other than the good future prospects, DNOW demonstrated that it could deliver consistent financial performance as shown in the chart below:

(click to enlarge)03May20171348591493837339.png

Source: Company Presentation

From historical perspective, other than the fact that DNOW has experienced poor revenue growth in 2013 due to slowdown in the energy sector, DNOW can maintain consistent profit margins. This shows the financial stewardship of the management team of DNOW to run the business. Not to mention that as DNOW being a stand alone company nowadays, the management team of DNOW has already provided guidance to improve profit margins to 8% and above.

Since DNOW is a GARP investment candidate, I would like to discuss the earnings growth in addition to the FCF growth discussed above. The current street consensus of DNOW is $2.30 EPS in 2016. I believe that the EPS target in 2016 is achievable since DNOW is expected to do accretive M&A, 3-5% organic market share gain, and margins expansion. As DNOW having $2.30 EPS in 2016 and applying 16x P/E multiple, DNOW can trade close to $36.

Averaging both the price targets derived from the P/E multiple and EV/EBITDA ratio, my final target price of DNOW is approximately $38, which implies 37% upside potential.

Risks

First, the oil and gas demand growth is expected to be weak in the near future. As a result, the oil and gas price has been in decline recently. In addition, Barron's published a report predicting oil prices could decline to $75. Although this is the macro headwind, which is out of management's control, it should be carefully taken into consideration when making an investment in DNOW.

Second, DNOW might do dilutive acquisitions or face difficulties in integrating future acquired companies in the future. This poses execution risk. However, having an experienced management team dealing with mergers and acquisitions, such risk is dramatically reduced for prospective investors.

Third, although DNOW has the economies of scale to compete in the industry, its close competitor, MRC Global, can be a threat. In addition, there is no long-term contract between DNOW and its customers with specific details dictating the annual sales amount DNOW can demand. Customers might leave DNOW for its competitors without incurring significant losses. This poses some business risk for investors to consider before making investment in DNOW.Â

The Bottom Line

This is my first post to recommend a stock currently trading at a reasonable price. However, I believe that I have already made it clear why DNOW deserves to be part of our long-term portfolio. With the highly favorable reward profile in DNOW, I believe that the current depressed oil price renders great entry point for prospective investors to buy into DNOW.

Disclosure: I am not a securities broker/dealer or an investment adviser. You are responsible for your own investment decisions. All information contained should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.